As of July 15, 2017, the Colorado Division of Securities (“CDS”) adopted Rule 51-4.11(IA) of the Code of Colorado Regulations which exempts certain investment advisers whose sole clients are qualifying private funds from having to register with the state (the “Colorado Private Fund Adviser Exemption”). Investment advisers that meet the requirements of the Colorado Private Fund Adviser Exemption can file as an exempt reporting adviser (“ERA”) with the CDS. Previously, such investment advisers located in Colorado were required to register with the state. The Colorado Private Fund Adviser Exemption generally mirrors the SEC’s private fund adviser exemption and similar exemptions of other states; however, there are some important differences as discussed below.
Colorado Private Fund Adviser Requirements Generally.
In order to take advantage of the Colorado Private Fund Adviser Exemption, an investment adviser must:
provide investment advice solely to one or more “qualifying private funds” as defined by the SEC (generally, any private fund not registered under the Investment Company Act of 1940, as amended, (e.g., a 3(c)(1) or 3(c)(7) fund));
not be subject to any “bad actor” disqualification events under Regulation D (this does not apply specifically to SEC ERAs);
file a report (generally, Part 1A of the Form ADV) and any amendments thereto required of an SEC ERA; and
pay the fees prescribed by the Colorado securities commissioner.
Additional Requirements for Certain 3(c)(1) Fund Advisers
Investment advisers to 3(c)(1) funds that are not “venture capital funds” (as defined by the SEC) (such 3(c)(1) fund, a “Non-VC 3(c)(1) Fund”) must also satisfy the following conditions with respect to each Non-VC 3(c)(1) Fund:
such Non-VC 3(c)(1) Fund’s securities may only be beneficially owned by persons who, after deducting the value of the primary residence from such person’s net worth, meet the qualified client definition (which deviates from the accredited investor threshold adopted by some states);
disclose the services, duties and other material information affecting the rights and responsibilities of each beneficial owner, if any; and
obtain and deliver annual audited financial statements to the Non-VC 3(c)(1) Fund’s investors.
Relief from “Gatekeeper” Requirement
Generally, Colorado investment advisers to pooled investment funds must engage an independent representative (a CPA or attorney) as a “gatekeeper” to review all fees, expenses and capital withdrawals from the pooled investment fund. However, an investment adviser availing of the Colorado Private Fund Adviser Exemption is not subject to this requirement and, thus, is not burdened with the obligation or expense to engage such third-party gatekeeper.
Transitioning to Registration and SEC Eligibility
Investment advisers no longer eligible for the Colorado Private Fund Adviser Exemption must register with the state within 90 days of such ineligibility. Moreover, once an adviser’s assets under management equals or exceeds $110 million as of an annual updating amendment to Form ADV, such adviser must file as an SEC ERA or register with the SEC, as applicable.
The Colorado Private Fund Adviser Exemption is a welcomed and useful exemption for Colorado private fund advisers. If you would like assistance in filing for the exemption or have any questions, please contact Scott Kitchens (415-762-2847) or Tony Wise (415-762-2863) at Cole-Frieman & Mallon LLP’s Denver office.
Cole-Frieman & Mallon is a boutique law firm focused on providing institutional quality legal services to the investment management industry. Please contact us if you would like more information on this topic.
We hope you have had an enjoyable summer. While the third quarter is typically quieter than the second quarter from a compliance perspective, we continue to see meaningful enforcement actions pursued by regulatory authorities. As we move into the fourth quarter, we want to provide an overview of items we hope will help you stay up to date with regulatory requirements.
SEC Expands the “Accredited Investor” and “Qualified Institutional Buyer” Definitions. On August 26, 2020, the Securities and Exchange Commission (“SEC”) adopted amendments to the “accredited investor” definition under Rule 501(a) of Regulation D under the Securities Act of 1933, as amended (the “Securities Act”), which include additional categories of natural persons or entities who may qualify as accredited investors. Notably, certain of the new categories will enable natural persons to qualify as accredited investors on the basis that they have the requisite ability to assess an investment opportunity based on measures of professional knowledge, experience or certifications, irrespective of whether these persons meet any income or net worth thresholds. The SEC also amended the “qualified institutional buyer” definition under Rule 144A of the Securities Act to include institutional investors contained in the accredited investor definition so long as they meet the $100 million in securities owned and invested threshold. The amendments were published in the Federal Register on October 9, 2020 and will become effective within 60 days after such publication (i.e., December 8, 2020). Managers should review their fund documents to determine which documents will need to be updated to include the amendments to the accredited investor definition. Our recent blog post addresses FAQs we have received on the updated definition.
Private Funds Risk Alert. The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) published a Risk Alert identifying commonly observed key deficiencies in OCIE’s examinations of advisers to private funds. Notably, OCIE found investors in private funds may have paid more in fees and expenses as a result of these deficiencies, which included inaccurate allocations of fees and expenses, failures to value client assets in accordance with valuation policies and failures to track, apply and/or calculate fees received from portfolio companies (whether or not such fees were used to offset management fees received by the adviser). OCIE also highlighted inadequate conflicts of interest disclosures, finding that many advisers did not provide investors with sufficient detail regarding conflicts related to allocation of investments among the adviser’s clients and conflicts related to investments in the same portfolio company made by multiple clients of an adviser and co-investments. Managers should review their allocation policies as well as disclosures regarding potential allocations of investments among clients to ensure that adequate and clear disclosures are included.
Reg BI FAQ Updated with Guidance for Broker-Dealers When Using “Adviser/Advisor”. In response to confusion raised by broker-dealers, the SEC has indicated in a handful of recent updates to its FAQs regarding Regulation Best Interest (Reg BI) that a broker-dealer generally may not use the term “adviser” or “advisor” to refer to itself unless it is registered as an investment adviser (an “RIA”), subject to certain limited exceptions. The SEC’s responses included examples of common situations when broker-dealers typically may refer to themselves as “advisers” or “advisors” when not so registered, including when such broker-dealer is acting in a role defined by statute such as a municipal advisor or commodity trading advisor. Reg BI’s disclosure obligation requires in-scope broker-dealers and investment advisers to disclose to retail customers all material facts relating to the nature and terms of the relationship between them as well as all material facts relating to conflicts of interest that are associated with the recommendation. As discussed in our previous update, compliance with Reg BI was required as of June 30, 2020. Given the nascence of the Reg BI requirements we expect the SEC to continue updating the Reg BI FAQs to address other common confusion or Reg BI deficiencies identified in examinations of investment advisers and broker-dealers.
SEC Charges CA Adviser for Misappropriating Client Funds. In a recent enforcement action, the SEC charged a California adviser with violating the antifraud provisions of the Securities Exchange Act of 1934, as amended, the Securities Act and the Investment Advisers Act of 1940, as amended (the “Advisers Act”). The SEC alleges that during the adviser’s association with other SEC-registered firms, the adviser acted alone and through his company to misappropriate client funds (including the sale of client securities and diverting the proceeds for his use) and make other material misrepresentations and omissions. The SEC’s complaint further alleges that the adviser actively took steps to conceal his misconduct from existing and future advisory clients, including forging a letter from his client indicating that the client had gifted him the misappropriated funds. The adviser further failed to disclose to prospective clients that his affiliation with one of the SEC-registered firms had been terminated for stealing client funds. While the alleged conduct is particularly egregious, this action serves as a reminder that investment advisers owe their advisory clients a fiduciary duty to place the clients’ interest ahead of their own and to disclose all material facts to the clients about their investment.
SEC Charges Fund Adviser with Antifraud Violations. The SEC was granted emergency relief to stop an RIA (and its sole individual owner) from continuing to offer interests in a private fund it managed and destroying documents which may contain evidence of fraudulent conduct. In soliciting investors for the fund, the SEC alleges that the RIA not only misrepresented the fund’s past performance, the amount of assets managed and the owner’s experience as a portfolio manager, but also falsified brokerage records and investor account statements, and sent fake audit opinions to investors and third parties. As an example of the fraudulent conduct, the SEC’s complaint alleges that a document provided to the fund’s investors and potential investors showed 37 months of positive monthly performance when the fund actually had approximately 26 months of negative monthly performance during the applicable time period. The SEC charged the RIA and its owner with violating the antifraud provisions of federal securities laws and charged the individual owner with aiding and abetting the RIA’s violations of the Advisers Act. The SEC is seeking injunctions, disgorgement of allegedly ill-gotten gains with prejudgment interest and financial penalties.
SEC Brings Action Against Manager for Expense Disclosure and Allocation Failures. In a recent enforcement action demonstrating the SEC’s continued scrutiny of the adequacy of fund managers’ expense disclosures and expense allocation procedures, the SEC censured a Florida-based RIA for failing to properly disclose and allocate to the applicable funds the expenses of “third party tasks” performed by the RIA “in-house.” The SEC cited the firm for failing to properly allocate these expenses between the applicable funds and co-investment vehicles managed alongside the funds, resulting in the funds being charged more than their pro rata share of the costs and expenses of reimbursing the firm for the third party tasks. In violation of the Advisers Act, the SEC found that the firm failed to adopt any written policies and procedures reasonably designed to properly disclose, calculate and allocate such that third party task expenses. Managers should review their fund documents and consider whether they sufficiently disclose expenses borne by the applicable fund as well as whether the manager has adequate policies and procedures in place regarding allocating expenses between the applicable fund and other funds or clients of the manager.
SEC Charges NY Firm and CCO for Compliance Failures. The SEC recently censured a dually-registered investment adviser and broker-dealer firm and its chief compliance officer (“CCO”) for failing to adhere to written policies and procedures implemented to remedy deficiencies discovered in a previous examination of the firm’s compliance program. The SEC further found that the CCO not only failed to conduct the monthly compliance reviews required under the program, but also altered monthly review documents that were provided to the SEC in a subsequent examination to give the appearance that the reviews had been conducted during the period covered by the SEC’s examination. To settle the charges, the firm and CCO paid a penalty of $1,745,000 and agreed to cease and desist from committing future violations of the antifraud provisions of the Advisers Act. The CCO was also barred from associating with any broker-dealer or investment adviser, subject to a right to reapply for association in the future, and prohibited from serving or acting as an employee or similar of an advisory board, investment adviser or depositor of, or principal underwriter for, a registered investment company, or an affiliated person of such investment adviser, depositor or principal underwriter.
Cayman Islands Amends the Private FundsLaw. On July 7, 2020, the Cayman Islands Monetary Authority (“CIMA”) further amended the Cayman Islands Private Funds Law 2020 (the “PF Law”) to expand the definition of a private fund (“Private Fund”), thereby extending the scope of the PF Law to additional closed-ended entities which must now register with CIMA. The revised definition provides that a Private Fund is any company, unit trust or partnership that offers or issues (or has issued) investment interests to investors with the aim of providing such investors profits or gains from investments; provided that, (i) the investors do not have day-to-day control of the entity’s investments and (ii) the investments are managed by or on behalf of the entity’s operator. The PF Law also specifies narrow categories of persons or any non-fund arrangements that are not included in the Private Fund definition and, thus, do not need to register with CIMA. Entities that now fall under the Private Fund definition were required to register with CIMA by August 7, 2020. Managers of Cayman Islands closed-ended vehicles that have not registered with CIMA should discuss this matter with counsel.
BVI Financial Services Commission Issues Guidance on Digital Assets. On July 13, 2020, the British Virgin Islands (“BVI”) Financial Services Commission (“FSC”) issued guidance clarifying the regulatory framework applicable to digital assets. The guidance, which is part of the FSC’s burgeoning regulation of digital assets and investment activities related to digital assets, clarifies the types of digital asset products that may be captured under the Securities and Investment Business Act, 2010 (“SIBA”), either (i) when the products are initially issued or (ii) when the products are in the hands of a holder or the subject of a regulated investment activity after issuance. The guidance provides an illustrative table of the types of digital asset products that may be regulated under SIBA, although additional analysis may be required for certain types of digital asset products, such as digital assets that create an entitlement to shares, interests or debentures. The FSC is allowing a 6-month compliance period from the date of publication during which any relevant entity may submit an application for the applicable license or certificate. If a digital asset product falls within the definition of an “investment” under SIBA, persons carrying on an investment business activity with respect to such digital asset products will need to be licensed with the FSC by January 13, 2021. Managers should review and consider whether they are or may be engaged in any regulated investment activities in or from within the BVI such that a license from the FSC is required.
Digital Asset Matters
INX Launches First SEC-Approved Blockchain IPO. INX Ltd., a Gibraltar-based company (“INX”), launched the first SEC-registered token IPO after the SEC declared that the registration statement relating to the offering of INX’s security tokens was effective on August 20, 2020. INX will allow investors to purchase INX tokens with certain cryptocurrencies and stablecoins as well as the U.S. dollar as it raises funds to further develop a multiservice digital asset platform aimed at providing its customers with a single entry-point for the trading of cryptocurrencies, security tokens and their derivatives. INX notes that INX tokens have both security and utility benefits for their holders: (i) as a security, by entitling the holders to a mandatory profit share of INX’s profit and a liquidation preference and (ii) as a utility, by providing a discount on transaction fees charged via INX’s platform when used to pay the fees and when used for staking on INX’s platform.
ConsenSys Acquires Quorum, JP Morgan’s Blockchain Platform. ConsenSys, a blockchain software company, recently announced its acquisition of Quorum, an enterprise-variant of the Ethereum blockchain developed by J.P. Morgan. Through the acquisition, ConsenSys seeks to increase the availability of Quorum’s features and capabilities, such as digital asset functionality and document management, by offering a range of products, services and support for Quorum, which will become interoperable with other blockchain products offered by ConsenSys. J.P. Morgan, which also made a strategic investment in ConsenSys in connection with the acquisition, will become a customer of ConsenSys and will utilize the advanced features and services ConsenSys will provide for Quorum. J.P. Morgan’s development of Quorum and its partnership with ConsenSys are additional examples of the growing institutional adoption of blockchain technology and acceptance of digital assets.
SEC Charges Virginia-based Issuer of Unregistered ICO. In a recent enforcement action, the SEC found that a company and its CEO conducted an unregistered initial coin offering (“ICO”) in connection with its development of a platform to link employers and freelancers. The company raised approximately $5 million in the ICO, selling 125 million tokens to approximately 1,500 investors. The SEC found that the tokens were “securities” under the Howey Test since an investor would have had a reasonable expectation of profit based upon the company’s efforts. Therefore, the tokens could have only been sold through a registered offering or under an exemption from registration requirements. The order also describes the company’s and the CEO’s misrepresentations related to the technical capabilities of the platform and the stability and security of the tokens. The company was ordered to disgorge the monies raised in the ICO and to pay pre-judgment interest of over $600,000. The CEO was individually required to pay a penalty of $150,000, and was barred from serving as an officer or director of a public company and from participating in future offerings of digital asset securities.
CFTC Prohibits Regulation 4.13 CPO Exemptions to Certain Persons Subject to Statutory Disqualifications. The CFTC approved a final rule amendment to Regulation 4.13 of the Commodity Exchange Act of 1934, as amended (the “CEA”), which prohibits a person from claiming an exemption from registration as a commodity pool operator (“CPO”) pursuant to Regulation 4.13 if the person or any of its principals are subject to any of the statutory disqualifications listed in Section 8a(2) of the CEA (the “Covered Statutory Disqualifications”). Previously a person claiming an exemption under Regulation 4.13, which includes the often-used “de minimis exemption” pursuant to Regulation 4.13(a)(3), was not required to represent that it was not subject to a Covered Statutory Disqualification to qualify for such exemption. Notably, the changes are not applicable to family office CPOs claiming the exemption under Regulation 4.13(a)(6). The amendment became effective on August 4, 2020. After the effective date, persons who wish to claim an exemption under Regulation 4.13 will need to represent that neither they nor their principals are subject to the Covered Statutory Disqualifications. For a CPO relying on an exemption prior to the effective date, the CFTC has determined not to mandate compliance until March 1, 2021, which is also the deadline for CPOs to file an annual reaffirmation notice for continued reliance on an exemption. As such, firms that wish to claim or reaffirm an exemption under Regulation 4.13, with the exception family office CPOS, will need to determine whether any of their principals have a Covered Statutory Disqualification in their background.
Form BE-180 Requirement for U.S. Managers and Funds. The Bureau of Economic Analysis at the U.S. Department of Commerce (the “BEA”) requires certain U.S. Financial Service Providers (including investment advisers, funds and their general partners) that engaged in a financial services transaction with a foreign person during their 2019 fiscal year to file a report on Form BEA-180 (the “Form”). This requirement will apply to any of our U.S.-based clients that are investment advisers or general partners to an offshore fund, and certain other clients as well. The Form is a 5-year benchmark survey and the deadline to file the Form electronically is October 30, 2020.
The Form requires additional transaction-specific information from Financial Service Providers that either sold financial services to foreign persons in excess of $3,000,000, or purchased financial services from foreign persons in excess of $3,000,000. Please note that sales and purchases are calculated separately, meaning if a Financial Service Provider exceeds the threshold with respect to sales but not purchases, the requirement to provide additional transaction-specific information on the Form would only apply with respect to sales transactions.
Please see our previous post for more information as to who is considered a “Financial Service Provider” and what types of transactions are covered, as well as common scenarios that may apply to some of our clients.
In early September our own Bart Mallon hosted a discussion forum with panelists from tax, compliance and legal firms which explored issues currently affecting digital asset managers, including among others DeFi, custody and regulatory developments. You can find a useful recap of the event on our blog. Later in the month, Cole-Frieman & Mallon LLP also co-sponsored a very well received fireside chat with Matthew Goetz of BlockTower Capital, in the second of an ongoing series of CoinAlts Fund Symposium webinars.
Compliance Calendar Please note the following important dates as you plan your regulatory compliance timeline for the coming months.
Review holdings to determine Form PF filing requirements.
Amendment to Form 13H due if there were changes during Q3.
SEC deadline to file 3rd Quarter 2020 Form PF for quarterly filers (Large Liquidity Fund Advisers), through PFRD.
Extended deadline to file Reports of Foreign Bank and Financial Accounts (FBAR).
Form BE-180 due for managers and funds filing electronically to report sales or purchases to foreign persons for covered financial transactions, through BEA eFile.
Registered CPOs must distribute (i) monthly account statements to pool participants (pools with net asset value of more than $500,000) and (ii) quarterly account statements to pool participants (pools with net asset value less than $500,000 or CPOs claiming the 4.7 exemption).
Registered investment advisers must collect access persons’ personal securities transactions.
National Futures Association (“NFA”) deadline to file Form PR for registered CTAs. through NFA EasyFile.
Investment adviser firms may view, print and pay preliminary notice filings for all appropriate states, through IARD.
SEC deadline to file Form 13F for 3rd Quarter of 2020.
*Extended deadline pursuant to COVID-19 pandemic-related relief
Please contactus with any questions or for assistance with any of the above topics.
Karl Cole-Frieman, Bart Mallon, Lilly Palmer, David Rothschild, & Scott Kitchens
Cole-Frieman & Mallon LLP is a premier boutique investment management law firm, providing top-tier, responsive, and cost-effective legal solutions for financial services matters. Headquartered in San Francisco, Cole-Frieman & Mallon LLP services both start-up investment managers, as well as multi-billion-dollar firms. The firm provides a full suite of legal services to the investment management community, including hedge fund, private equity fund, venture capital fund, mutual fund formation, adviser registration, counterparty documentation, SEC, CFTC, NFA and FINRA matters, seed deals, hedge fund due diligence, employment and compensation matters, and routine business matters. The firm also publishes the prominent Hedge Fund Law Blog, which focuses on legal issues that impact the hedge fund community. For more information, please add us on LinkedIn and visit us at colefrieman.com.
The Bureau of Economic Analysis at the U.S. Department of Commerce (the “BEA”) requires certain U.S. Financial Service Providers (including investment advisers, funds and their general partners) that engaged in a financial services transaction with a foreign person during their 2019 fiscal year to file a report on Form BEA-180 (the “Form”). This requirement will apply to any of our U.S.-based clients that are investment advisers or general partners to an offshore fund, and certain other clients as well. Some of our clients may have been notified to complete this Form directly by the BEA, however even clients who have not been contacted may be required to submit the Form.
The Form is a 5-year benchmark survey and the deadline to file the Form electronically is October 30, 2020. Please note the deadline of September 30, 2020 for paper filers has passed. The Form requires additional transaction-specific information from Financial Service Providers that either sold financial services to foreign persons in excess of $3,000,000, or purchased financial services from foreign persons in excess of $3,000,000. Please note that sales and purchases are calculated separately, meaning if a Financial Service Provider exceeds the threshold with respect to sales but not purchases, the requirement to provide additional transaction-specific information on the Form would only apply with respect to sales transactions.
“Financial Service Provider” is broadly defined by the BEA and includes domestic investment advisers, funds and their general partners. Examples of covered financial services transactions include brokerage services, financial management services and security lending services. A direct investment in a foreign person is not a covered financial services transaction, however brokerage fees to a foreign person tied to underwriting the transaction, for example, do qualify as a covered financial service transaction if the purchase occurred in 2019. More information about each category of covered financial services transactions may be found in Section VI of the Form’s instructions.
If the BEA has contacted a Financial Service Provider directly, it must complete the Form even if it has no transactions to report.
We have outlined below a few common scenarios that may apply to our clients:
A domestic investment adviser or general partner that receives fees (including management and/or performance fees) from an offshore investment fund must complete the Form. Depending on the offshore fund structure, a management company may receive a fee either from the offshore fund itself, or directly from the underlying foreign investors in the offshore fund. In either example, the offshore fund and the underlying foreign investors, as applicable, are “foreign persons” and the investment adviser’s services are “financial services transactions” for purposes of the Form. Management companies should only report fees received from foreign investors in a U.S. fund if the fee is charged directly to a foreign investor, rather than charged to the U.S. fund itself.
If a domestic fund has engaged in any covered financial services transactions with foreign persons, the fund may also need to complete the Form.
We would like to note for our clients that entities in a parent-subsidiary relationship may be able to file as a consolidated domestic U.S. enterprise. The parent-subsidiary relationship turns on whether one entity owns more than 50% of the other’s voting securities, and the instructions specifically state that for a limited partnership, the general partner is presumed to control and have a 100% voting interest unless there is a clause to the contrary in the limited partnership agreement. As such, it is likely that many of our clients will be able to report as a consolidated enterprise, completing just one Form for the general partner and domestic fund, as applicable (and filing a separate Form on behalf of the investment adviser in bifurcated management company structures).
Failure to submit the Form or comply with any of its reporting requirements may result in a civil penalty between $2,500 and $25,000 and/or injunctive relief. Further criminal penalties may arise upon willful violation of the reporting requirements under this Form.
The Form must be submitted via the BEA’s e-filing system here, and the paper copy can be found here (for reference only). Please contact us if you have any questions as to your requirements.